What have the U.S. Treasury and more ICOs in common?
It all goes back to 1600th century tulip craze……and ends up with the mechanism we at letsbet.io chose for our token sale. In this article we introduce the fascinating history of a Dutch auction and explain why this old but effective method found its way into the blockchain world.
The history of Dutch Auctions
The history and origin of the Dutch Auction is actually a fascinating look at many of the same economic themes and issues we look at today. Microeconomic themes like supply and demand, finance themes like futures and options, and auction theory themes like first price and efficient pricing all were explored in 1600’s Holland, hundreds of years before they were considered the science they are today.
Let’s start by taking a look back historically at the origin of the Dutch Auction. It’s the early 1600’s in Holland, and the tulip bulb has recently been introduced to the country by traders from the Ottoman empire. The flower is unique and unlike any other flower in Europe at the time. It’s tough to imagine in today’s world where people are familiar with everything the world has to offer, but imagine seeing a bright purple dog for the first time. People would want it based simply on its uniqueness. The same instant demand occurred in the tulip market, and the people wanting to own the flower for themselves started to grow quickly. A demand curve that didn’t exist initially suddenly appears and starts moving up quickly.
However, the botanical limitations of the tulip serve to constrain the supply curve. It takes 7–12 years to grow a tulip from a seed to its tradable asset, the bulb. And the most popular bulbs, the multi-colored bulbs, would take even longer to grow. So with a quickly growing demand curve, and a relatively fixed supply curve with an extremely long production cycle, the possibility for a spike in prices is extremely high.
Let’s throw a few more variables into this Dutch tulip market. The flower only blooms during April and May. During the Summer months, the flower returns into its bulb form, which means it can be dug up and moved around. The rest of the year, the tulip must be in dirt and doesn’t show a flower. Essentially, the tulip can only be traded for 3 months a year, but the market and demand exist all year round. What resulted was the first modern futures contract — at any time during the year, tulip sellers and tulip buyers would sign a contract to deliver X amount of tulips on a given date in the Summer at price Y. Further, these contracts could be traded amongst other buyers and sellers to create a functional futures market. So, the futures market as we know it today is a direct result of the Dutch traders wanting to buy and sell tulips year-round despite being botanically limited to physically trading them and delivering them for only 3 months a year.
Finally, during the height of the Panic, the Dutch Parliament passed a law in an effort to curb the panic that stated that all futures contracts could be canceled at any point if the buyer paid the seller 3.5% of the contract price. A contract that can be canceled at any point with only a fixed price paid to the seller for the right to cancel — sounds an awful lot like an option to me! Yes, even the primitive option market was created during the Dutch Tulip Panic. As modern finance could predict however, with only a small penalty for misguided speculative bets, these new option contracts exacerbated the problem by allowing traders to increase their bets through massive leverage. Sometimes creating new financial instruments can lead to unintended negative consequences!
Back to the Dutch Auction. Now that you know the background of the tulip market, you can picture the crazy scene at the Exchange: traders milling around talking loudly, the noise, the hubbub, the contracts flying around. Total commotion, very noisy, and very hard to keep everything organized. The Exchange figured, correctly, that the best solution to selling the bulbs was to do it quickly, to do it with as few bids as possible, while at the same time getting as high a price as possible.
The Dutch auction bought order into this chao. A true Dutch Auction has the following attributes: it starts at an artificially high price, where demand is known (or believed) to be 0. At publicly known time intervals, the price ticks down in publicly known price increments. The price continues to tick down until the first bid is received. At this point, the auction ends immediately, and the bidder wins the product at the price when he placed his bid.
U.S. Treasuries and Dutch auctions
The U.S. Treasury uses a Dutch auction to sell its securities. To help finance the country’s debt, the US Treasury holds regular auctions to sell Treasury bills (T-bills), notes (T-notes), and bonds (T-bonds), collectively known as Treasuries. Prospective investors submit bids electronically through TreasuryDirect or the Treasury Automated Auction Processing System (TAAPS) which accepts bids up to 30 days in advance of the auction. Suppose the Treasury seeks to raise $9 million in two-year notes with a 5% coupon. Let’s assume the submitted bids are as follows:
$1 million at 4.79%
$2.5 million at 4.85%
$2 million at 4.96%
$1.5 million at 5%
$3 million at 5.07%
$1 million at 5.1%
$5 million at 5.5%
The bids with the lowest yield will be accepted first since the issuer will prefer to pay lower yields to its bond investors. In this case, since the Treasury is looking to raise $9 million, it will accept the bids with the lowest yield up to 5.07%. At this mark, only $2 million of the $3 million bid will be approved. All bids above the 5.07% yield will be accepted, and bids below will be rejected. In effect, this auction is cleared at 5.07%, and all successful bidders receive the 5.07% yield.
ICO’s and Dutch auctions
If a company is using a Dutch auction Initial Coin Offering (ICO), potential investors enter their bids for the number of shares they want to purchase as well as the price they are willing to pay. For example, an investor may place a bid for 100 coins at $100 while another investor offers $95 for 500 coins.
Once all the bids are submitted, the allotted placement is assigned to the bidders from the highest bids down, until all of the allotted shares are assigned. However, the price that each bidder pays is based on the lowest price of all the allotted bidders, or essentially the last successful bid. Therefore, even if you bid $100 for your 1,000 coins, if the last successful bid is $80, you will only have to pay $80 for your 1,000 tokens.
Why bringing together Dutch Auction and blockchain technology? There are two main reasons: transparency and price discovery. In a Dutch Auction, each bidder has complete visibility as to the total available supply, current price, and changes in price over time. This mechanism achieves price discovery — every participant can bid for any amount of the supply at what they believe to be the correct price, and each bid is visible, so every subsequent bidder benefit immediately from the bid information in making their own decision about the correct price. It’s the perfect example of an open and transparent market mechanism that efficiently builds a fair price.
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